There’s a practical rule of thumb that has worked over many markets and many periods of time about expected returns for stocks, government bonds and cash. It is:

stocks return inflation + 6% annually;

(long-dated) government bonds return inflation + 3% annually; and

cash returns inflation + (maybe) 1% annually.

In the absence of any specific insight about the current period (for example, I think stock returns will be higher than this rule implies over the next year or two), this is a reasonable starting point for a projection.

If the long bond is the 30-year, and if inflation will on average be 2% over the life of the bond, then the yield should be about 5%.

For the ten-year, the yield should be around 4%.

For cash, a “normal” yield should be around 2%. We know, though, that the Fed has made short rates as strongly negative in real terms as it can, because of the financial crisis.

The first thing to note is that the last bout of inflation the US has experienced was in the Seventies. This means you’d have to be close to sixty years old to have lived through an inflationary period as a working adult. Said in a different way, almost no one who is writing and speaking about the inflation threat today has any practical experience of the phenomenon. To my mind, most of these commentators have no clue about what inflation is or does. Continue reading →

Let’s begin by looking at the effect that changes in the rate of inflation can make on the real return from buying a 10-year bond. Don’t worry about whether the example is particularly realistic. I mostly want to illustrate what happens when inflation changes.

Assume we’re the lender and we’ve just bought the bond with a coupon of 4% at par for $1000. The transaction happens in the belief that inflation will be 1% per year, meaning an anticipated real return of 3% per year on the money we have lent. This implies the present value of the repayment of principal is expected to be $905 and the present value of the coupon payments (ignoring any real gains or losses on their reinvestment) is, say, $360. The total is $1265.

Suppose, right after we’ve bought the bond, inflation suddenly drops to zero and stays there. Then the return of principal has a present value of $1000 and the coupon payments are worth $400. The total is now $1400, which has just raised the cost to the borrower by about 11%, and boosted our return by the same amount. We stand to make a windfall!

On the other hand, suppose inflation shoots straight up to 4% annually, completely wiping out the real return from the coupon payments. The return of principal now has a present value of $675, and the coupons are worth about $335. In other words, the borrower gets the use of the $1000 for ten years basically for free. We have no more money at the end of the ten years than we had at the beginning.

Even worse, let’s say inflation gets dialed up higher, to 6% per year. The principal repayment is now worth $558 in today’s dollars and the coupons are worth about $300. So we’re suddenly taking a bath!?! We’re in the position that we stand to lose about 15% of our money . The borrower will have the use of the funds for ten years but will pay back far less than he borrowed in the first place.

I’m going to write about this topic in three posts: inflation-general; inflation as politics; and, what makes inflation a threat to the US today. Here goes:

What inflation is

Inflation is a rise in the overall level of prices. It isn’t enough to have a few prices, even highly visible prices, rising. Prices in general have to be rising to have inflation. The inflation rate, which is what commentators usually write about, is the speed at which prices are rising, usually at an annual rate.

Having inflation is better than having its opposite, deflation, or a fall in the general level of prices. Deflation is harder to fix and has far worse consequences, especially in paying off debt, than inflation. The last serious bout of deflation in the US was during the Great Depression of the 1930s. (The two other terms typically used in talking about this topic are: disinflation, or inflation that is advancing at a declining rate–the situation in the US since the early Eighties; and stagflation, the situation where real economic growth is very slow but the inflation rate is high, as was the case for much of the Seventies.)

When investors think about GDP growth, their thoughts automatically go to the Keynesian framework they learned in school–GDP is a function of consumption + investment + government spending + net exports. In assessing a country’s overall prospects, however, I’ve found it more useful to consider GDP growth from a labor point of view. This method is especially pertinent in developed economies, where the combination of large accumulated wealth and low birth rates make labor the scarce factor of production.

A simple idea

The idea is very simple. Real GDP is the total of a country’s output. That means it’s the product of the number of workers times average output per worker (productivity). Any increase in GDP requires some combination of having more people working or a rise in output per worker (i.e., productivity gains).

Here is the S&P 500 performance, by industry, since the beginning of April:

S&P 500 +14.3%

IT +12.3%

Industrials +21.7%

Consumer Discretionary +18.3%

Materials +16.5%

Energy +13.6%

Financials +40.1%

Healthcare +4.0%

Consumer Staples +7.7%

Utilities +2.7%

Telecom +1.0%

The results are pretty much as one would expect for an up market. The economically sensitive stocks have done very well. The defensives, though up have lagged behind the index badly. The only apparent anomaly is IT, which has lagged the index slightly. This is an S&P sector that contains an unusual mix of very mature companies that have very little growth and more vibrant firms that better fit the image of high-tech. The first camp includes MSFT (#1 in tech market cap), IBM (#2), and CSCO (#4), all of which have underperformed the S&P. The second has AAPL (#3) and GOOG (#5), which have outperformed. My guess is that MSFT will continue to be a drag on IT sector performance, but that the others will perk up as business spending improves.

I’ve been pleasantly surprised by the continuing resilience of world stock markets. I still think that it’s reasonable to expect 10-15% more upside in the next six months or so. More important, I think the pattern shown above, of outperformance by economically-sensitive sectors and underperformance by defensives, will continue. At some point, however, the market will begin to focus on the negatives surrounding the financials and their outperformance will likely cease. My preference has been to concentrate on financials with emerging markets exposure, but that’s just me. This is also a structural decision for me, since I know financials are not my strong suit.

Actively-managed ETFs have been allowed by the SEC since March 2008. Like actively-managed equity mutual funds, they fall into two types:

1. quantitative funds–that is, the fund sponsor creates a set of decision rules that are implemented without exception, typically by computer. The set may be simple, like: own equal dollar amounts of each of the 100 largest-capitalization stocks in the S&P 500. Or the rules might be more complex, with constraints on allowable book value, historical growth rates, consensus earnings estimates and other variables. There will also doubtless be a sub-rule dealing with borderline cases, to prevent having to trade in and out of a stock that flip-flops between #100 and #101. Otherwise, the “active” here consists in executing the rules.

2. “traditional” actively-managed funds–which make use of the subjective judgment of portfolio managers. These managers are supported in larger organizations by a staff of, among other possibilities, in-house securities analysts, quantitative analysts or an investment committee that creates an “approved list,” which specifies the only securities the manager is allowed to have in his portfolio. Discretion given to the manager in forming strategy and selecting stocks runs the gamut from the manager having total control, on the one hand, to being more or less a client relationship manager for a portfolio structured completely by computer or investment committee, on the other.

You can find the general structural similarities in my earlier posts on ETFs vs mutual funds. The differences?